Finance, Investment and Sustainability

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FIN503 Finance, Investment and Sustainability

Assessment 3 – Written Assessment

Semester 1, 2023 Dr. D Chakrabarty

Maximum Marks: 45 (worth 45% of the overall assessment)

Due date: Friday, 9th June 2023, 23:59 hours, Darwin time

Instructions:

1. Download the Assignment Question file to complete your assignment.

2. Use Microsoft Word for the main assignment

3. You can use Microsoft Excel or calculator for numerical calculations.

4. When using Microsoft Excel, copy and paste Excel outputs (e.g. plots, tables) into your Microsoft Word document (to protect the formatting of Excel output, use the “paste as picture” option in Word.

5. How to Submit: Click in the submission box in the Assessment 3 folder and click on the attachment icon đź“Ž. Attach the file with the completed assignment (Word document only).

6. Keep a hard copy of the submitted assignment, in case there are problems with the electronic submission.

Important Notice:

As this is an individual assessment, students should submit their own assignment. All assignments submitted will go through a matching process. If found to have cheated/plagiarised, all submissions will receive a mark of zero for this assessment item. It is up to you to keep your assessment confidential.

This Assignment consists of three questions. Attempt all of them.

Question 1 [15 marks, 800 words]

Bank of Sydney has hired you as a financial analyst. One of your first job assignments is to analyze the present financial condition of Bradley Stores, Pty Ltd. You are provided with the following 2021 balance sheet and income statement information for Bradley Stores. In addition, you are told that Bradley Stores has 15,000,000 ordinary shares outstanding, currently trading at $10 per share, and has made annual purchases of $248,000,000.

Your assignment calls for you to calculate specific financial ratios and compare these calculated ratios with the industry-average ratios provided below. You are also told to base your analysis on five categories of ratios: (a) liquidity ratios, (b) activity ratios, (c) debt ratios, (d) profitability ratios, and (e) market ratios.

Answer the following questions to complete this job assignment.

(a) Identify which ratios you need to use to evaluate Bradley Stores in terms of its (a) liquidity position, (b) business activity, (c) debt position, (d) profitability, and (e) market comparability and calculate these ratios.

(Marks: 2)

(b) Based on the industry-average information, discuss Bradley Stores’ liquidity and business

activity. Discuss specific areas in which Bradley compares positively and negatively with the

overall industry.

(Marks: 3)

(c) Based on the industry-average information, discuss Bradley Stores’ debt position,

company profitability, and how it is viewed in the marketplace. Discuss specific areas in

which Bradley compares positively and negatively with the overall industry.

(Marks: 3)

(d) Overall, what are Bradley’s strong and weak points? Knowing that your boss will approve

new loans only to companies in a better-than-average financial position, what is your final

recommendation (approval or denial of the loan)? Justify your recommendation.

(Marks: 7)

Question 2 [15 marks, 700 words]

Part A (7 marks, 300 words)

Netflix Inc. is a subscription service and production company with a debt-equity ratio of 83% and 221.6 million subscribers worldwide as of 31st March 2022. On 19th April 2022, Netflix announced that it had suffered a net loss of 200,000 subscribers globally. It also said it expected to lose another two million subscribers over the next quarter. It was the first time that Netflix

had experienced a decline in worldwide subscription numbers since its inception. Before this announcement, Netflix shares were trading at $348.6 per share. Within two days, Netflix’s share prices fell to $218.2 per share, and by 10th May 2022, its shares were trading at $177.68 per share, an almost 50% decline in the share price of Netflix.

(i) Using the share price valuation models that we have studied, briefly explain the reasons behind such a dramatic decline in the share price of Netflix over just three weeks.

Part B (8 marks, 400 words)

Magic Production Company (MPC) is considering a recapitalization plan to convert MPC from its current all-equity capital structure to one including financial leverage. 

MPC now has 8 million ordinary shares outstanding, selling for $30.00 each. Currently, MPC shareholders have a required return of 20%. MPC’s expected earnings before interest and taxes (EBIT) is $48,000,000 per year for the foreseeable future. However, MPC earnings exhibit considerable volatility ranging between $8,000,000 to $88,000,000 over the last ten years. 

The recapitalization proposal is to issue $120,000,000 worth of long-term debt at an interest rate of 15 per cent and use the proceeds to repurchase as many shares as possible at $30.00 per share. Assume there are no market frictions such as corporate or personal income taxes. 

Write a short report for the CEO of MPC summarizing the benefits and risks associated with the recapitalization plan from the shareholder’s point of view. Your report should explicitly address the following questions:

(i) What are the number of shares outstanding and the debt-to-equity ratio for MPC if the proposed recapitalization is adopted? 

(Marks: 1)

(ii) What are the expected earnings per share (EPS) and the expected return on equity (ROE) for MPC shareholders under the proposed mixed debt/equity capital structure? How does it compare to the EPS and ROE under the current capital structure?  

(Marks: 2)

(iii) What risks are involved with moving from its current all-equity capital structure to the mixed debt/equity capital structure? 

(Marks: 5)

Filling up the following table will help you in answering these questions.

All Equity Financing

New Capital Structure

EBIT

Interest

Net Income

Shares Outstanding

Earnings per share (EPS)

Return on Equity (ROE)

Question 3 [15 marks, 700 words]

Reynolds Energy Company (REC) currently has 30,000,000 ordinary shares outstanding that trade at a price of $20 per share. REC also has 5,000,000 bonds outstanding that currently trade at $80 each. REC has no preferred equity outstanding and has an equity beta of 2.7. The risk-free rate is 3.5%, and the expected market return is 12.5%. The company’s bonds have a 20-year life, a $100 par value, a 10% coupon rate and pay interest annually. REC faces a tax rate of 20%.

Reynolds Energy has a $50 million capital budget from retained earnings and must make decisions regarding investment projects in the energy sector for the coming year. Projects 1 and 3 have high carbon emissions. Project 2 is an environmentally clean project. All projects generate revenue for five years only. The initial cash outflow and the earnings before interest and taxes (EBIT) resulting from these three projects are provided in the table below.

Project 1

Project 2

Project 3

Initial cash outflow

-$25,000,000

-$50,000,000

-$25,000,000

Year 1 EBIT

$20,000,000

$10,000,000

$15,000,000

Year 2 EBIT

$25,000,000

$20,000,000

$15,000,000

Year 3 EBIT

$10,000,000

$25,000,000

$15,000,000

Year 4 EBIT

$10,000,000

$25,000,000

$15,000,000

Year 5 EBIT

$10,000,000

$90,000,000

$15,000,000

NPV

IRR

PI

(a) Determine the appropriate discount rate for the REC projects. Provide a brief explanation of your calculations.

(Marks: 2)

(b) Derive the appropriate cash flow generated from the three projects. Provide a brief explanation of your calculations.

(Marks: 2)

(c) What is the Net Present Value (NPV), Internal rate of return (IRR) and Profitability Index (PI) of the three projects?

(Marks: 3)

(d) Which project/s should be chosen by REC if it wants to maximize shareholder wealth? Provide a brief explanation.

(Marks: 3)

(e) Suppose the government decides to implement a clean environment tax which imposes an additional 20% tax on earnings from projects with high carbon emissions. How would your answer to part (d) change due to this policy? Is the government’s policy successful? Provide a brief explanation.

(Marks: 5)

END OF WRITTEN ASSIGNMENT

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